The Elusive Grand Solution

Why markets can't get traction 
Raul Elizalde - Friday, September 30 2011

The challenges facing the developed world are clear: slow growth, weak banks, and a mountain of debt. With determination, cooperation, and skill, policymakers could resolve any single one these challenges. Confronting them all at once, however, presents a different problem: efforts directed at solving any one of these issues risks making another one worse.

This is the key to understand the extraordinary difficulty that the West encounters today. Policies to stimulate growth require additional debt; efforts to reduce debt can make banks weaker; making banks stronger can stifle growth.

This also explains why monetary and fiscal policies today pull in opposite directions. While central bankers drive down interest rates to historically low levels and drop money from helicopters, economy ministers impose draconian spending cuts and – in the case of Mediterranean Europe – huge tax increases. The result is that all stimulative benefits of easing monetary policy designed to support the banks are canceled out by tight fiscal policy directed at reducing public debt.

Better banks and less debt = slow growth

Banks with weakening balance sheets are a threat to any economy, and any sensible policymaker knows this. One way banks can help themselves is by lowering the risk profile of their assets – in other words, by cutting lending. This is exactly what is happening in the US today (see graph). But the private sector finds it hard to grow without being able to borrow, and households spend less as banks pull back on mortgages and revolving credit.


The government can help banks by absorbing their losses. This is what the Federal Reserve did in the early stages of the financial crisis in the US, when it purchased bad assets at 100 cents on the dollar from various financial institutions. The result was a transfer of debt from the private to the public sector (see graph).



The increase in public debt generated alarm among US and European politicians and so they pushed hard for spending cuts. As a result, both the private and the public sector went into heavy deleveraging at the same time. While this will probably succeed at improving bank balance sheets and the long-term fiscal outlook of government accounts, the inevitable outcome is that economic growth will slow.

Better banks and higher growth = more debt

The Keynesian argument is that when the private sector deleverages someone has to step in to keep the economy moving by picking up the slack of lending and spending. The inevitable conclusion is that maintaining economic growth requires the public sector to play that role. To keep the economy growing while helping the banks forces higher levels of debt. Strengthening the banks forces a choice between more debt and stronger growth.

Less debt and higher growth = weaker banks

Germany and core Europe have been exceedingly reluctant to let Greece default. This is because such an event would be a blow to European banks, which would have to book large losses not only on their large holdings of Greek debt, but also on holdings of other sovereign debt to which they heavily exposed and could be perceived as likelier to default if Greece does.

However, calls for European banks to book more substantial losses are increasing, as virtually everyone has come to the realization that creditors – the banks – will eventually have to take a hit on their exposure to Greece. The hope that the country will pay all its obligations in time and in full has vanished. But forcing a debt reduction by making banks eat up a large loss is tough medicine. How can the economy grow in such scenario?

Germany insists that the way of dealing with low leverage in the economy while maintaining growth is trough exports. At first glance this seems sensible: if internal demand is depressed, countries should look abroad to find sources of growth while cleaning up the banks and dealing with debt.

But, apart from the fact that it is mathematically impossible for all countries to be net exporters at the same time, such remedy ignores the fact that Germany itself extended huge amounts of credit to its European partners – one of the reasons why the weaker ones are now drowning in debt. For growth to exist, someone has to run up a tab.

A stark example of this dynamics can be found in the impressive growth of China’s exports, only possible through a massive amount of lending to its trading partners. One needs only to look at the mountain of foreign debt held by the People’s Bank of China to realize how true this is (see graph).



Germany can hardly expect that its export locomotive will continue to run at full speed if its European partners stop borrowing. For its export-led economy to chug along, it has to keep lending, or else write off at least some of its partners’ debt.

In fact this is exactly what is happening today as Germany commits itself to fund supra-national bodies ready to lend massive amounts of money to eurozone members in trouble. This increases Germany’s contingent liabilities to the tune of hundreds of billions of euros – and the resulting public backlash has prompted Merkel to renew calls for banks to foot more of the bill. The difficulty of shrinking debt without hurting the banks or affecting growth is evident.

No single solution

So these are the contradictions of the day. Solutions that can improve the banks, reduce debt and keep economies going are at odds with each other.

The only possible way of attacking all fronts at once is with a soft hand. Attempts to implement big, radical solutions to any single aspect of this conundrum can make any other much worse. The best example is Greece itself: the all-out measures directed at dealing with the country’s debt are crushing economic growth and posing a serious risk to the country’s banks.

Small steps are the West’s best bet. This will entail finding ways for targeted growth in some areas; accepting that some debts will not be paid in full; slowly recapitalizing some banks while other are allowed to fail; providing focused public stimulus in some areas; generating additional tax revenues in others. The process will be tortuous and grinding.

Politically this will be difficult in an environment of high unemployment, hardening ideological stances, and calls for “bold action.” Despite all the bitter accusations, no big announcement from European authorities, draconian measures in the periphery, or radical change in US policy will be able to loosen the knot quickly. Resolution will take time and hasty action will only make matters worse.

In this environment, the outlook for equities remains cloudy. If economic activity is constrained, so are earnings and equity prices (see graph).



However, the possibility that some sectors can perform better than others as growth proceeds in fits and starts could have a silver lining. If different sectors move at different speeds diversification benefits can improve, which have been notably absent from portfolios as stocks have tended to move up and down together in recent times

Interest rates are likely to remain low, since higher rates would affect banks by lowering the value of the bonds they hold. Long-term rates are of particular concern, and that’s why the Federal Reserve engaged in “Operation Twist” – far more effective at supporting the value of long-dated debt held by banks than at creating economic growth by reducing the cost of mortgages to consumers by a few basis points. Therefore the bonds may stay strong until either growth or inflation start to show – neither of which appears imminent.

Exchange rates may become more volatile as the West looks for external sources of demand. Emerging countries, most notably Brazil, have complained loudly about these “currency wars”, underscoring that this is already happening. Those investors who can predict directional moves and stomach the twists and turns of exchange rates may turn to currencies to generate returns at a time when equities values are capped and interest rates are low.

The bottom line is that investors confront a new set of challenges as the resolution of global problems proceeds at a glacial pace. High levels of cash could prove very useful under these conditions. Dry powder, and patience, may ultimately be the best tool to have in hand as the world works to break free of the ropes that bind it.

Raul Elizalde | raul@pathfinancial.net

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